Big Decisions — Judging an Uncertain Future from the Past

With recent estimates of pension deficits running into the multiple trillions, it now seems obvious that many decision makers in the past have somehow made some big mistakes.

Speaking at the 2014 Annual CFA Institute Conference in Seattle, Ronald J. Ryan, CFA, recalled that as recently as the late 1990s, pension plans — longtime investors in equities — had successfully achieved large surpluses but unfortunately decided not to use them to immunize their liabilities. Instead they chose to continue with high equity allocations and, by a seemingly clever accounting wheeze, adopted a return-on-assets objective to achieve a fully funded plan.

It turned out to be a disastrous decision. According to Ryan, solving the pension crisis now requires drastically better accounting rules, revolutionary asset allocation changes and bold approaches to risk management and indices. Hard to understand how big decisions — judging future uncertainties on past evidence — can go so wrong since it all seems so obvious now.

This is a classic example of the “benefit of hindsight,” a phenomenon put under the microscope by the low profile but insightful discipline of historiography, which studies the theory, technique, and process of historical scholarship. Historiography demonstrates the dangers of omitting awkward facts, exaggerating and altering records, using misleading meta-theories and revising data to suit an argument — in other words, telling lies.

In financial statistics, similar intellectual dishonesty sometimes shows up as look-back bias and data mining. Perhaps worst of all is retrophilia — projecting the favored social mores or opinions of today backwards onto the past. Ultimately, whether in political history or analyzing spreadsheets of historic data, when looking back we need to be very aware of where we are looking back from.

The success of any potential pension solution will only be possible to judge sometime in the future. But given the proclivity for such mistakes, how can investors today be expected to take good decisions under uncertainty about such important matters as pension fund asset allocation?

Anil Gaba, Professor of Risk Management at INSEAD Business School, spoke to me about some novel and practical solutions to resolve this challenge, at the 2013 CFA Institute Middle East Investment Conference. These include learning from both rational and irrational approaches to decision-making.

Relying on the past can be troublesome in other areas too, for example hiring decisions based on past achievements. According to Claudio Fernández-Aráoz, writing in the Harvard Business Review, the focus in hiring, promotion, and retention needs to shift toward the concept of personal potential to change. As the traditional investment disclaimer proclaims: “past performance does not guarantee future results.” The author explains how basing personnel decisions on prior results no longer makes sense. Indeed, traditional criteria — intelligence, talent, experience, etc. — are not sufficient metrics in the current uncertain business environment either.

Given the lack of past success by pension managers, one urgent challenge is how the growing number of defined contribution pension plan participants should allocate their assets. In particular, how much of the key risky asset — equities — should be selected? In “Evaluating Target-Date Glide Paths for Defined Contribution Plans,” the authors explore how employer sponsors with responsibility for pension plan asset allocation can compromise between the competing goals of achieving adequate lifetime income over retirement and limiting loss of capital.

Even more theoretically, decision-making is complicated by fluctuations in the views (or as researchers say “preferences”) of the decision makers. According to a new study from the Ecole Polytechnique Fédérale de Lausanne and California Institute of Technology, there may be time-varying sensitivities and decreased risk aversion for gains. Conventional models (prospect theory and mean variance optimization) assume stable preferences.

Another grey area related to the standpoint of the observer arises in ethics. Two thousand years ago it was acceptable to enslave large portions of the population and feed prisoners to lions as public entertainment for what today seem quite trivial reasons. Similarly, it may only become obvious over time that many obstacles can interfere with organizational objectivity and the recognition and detection of wrongdoing. Conflicts of interest can arise unseen. For example, supposedly independent auditors employed by HQ may be contracted in a remote division to supply services, thereby compromising their independence. Questionable ethical judgment can often start small, for example, when the back office gives a rogue trader who’s made a recording error the benefit of the doubt. But that approach can soon spiral into catastrophe as was seen with Jérôme Kerviel at Société Générale (GLE) and Kweku Adoboli at UBS (UBSN). One remedy is to become a “first-class noticer,” according to a recent article providing a number of useful tips by Max H. Bazerman.

Having the wherewithal to thoroughly appraise your standpoint both within an organization and across time and history might well be a challenge, but it seems to be imperative to successful long-term decision-making.

Recent CFA Digest summaries and related resources for interested readers to research are summarized below:

• The Global Pension Cliff: Myths, Realities, and Courses of Action CFA Institute Conference Proceedings Quarterly: In the late 1990s, pension plans did not use their big surpluses to immunize their liabilities. They believed that weighting equity investments and achieving a return-on-assets objective would ensure a fully funded plan. Pensions are now running critical deficits. Solving the pension crisis requires realistic accounting rules, a redefinition of traditional asset allocation and risk practices, and a focus on the custom liability index. This presentation comes from the 67th CFA Institute Annual Conference held in Seattle on 4–7 May 2014 in partnership with CFA Society Seattle.
• Better Investment Decisions under Uncertainty (Take 15 Series): Anil Gaba describes some of the challenges and solutions for investors of taking investment decisions under conditions of uncertainty.
• Risk and Reward Preferences under Time Pressure: Theories of choice in economics and finance assume that economic agents have stable preferences that are consistent with maximization of utility under prospect theory or mean-variance optimization. The authors experimentally investigate financial decision-making under time pressure and provide evidence that there may be time-varying sensitivities and decreased risk aversion for gains.
• The Big Idea: 21st Century Talent Spotting: The focus in hiring, promotion, and retention needs to shift toward the concept of personal potential to change. The author suggests how best to implement this new ideal. Reminiscent of the investment disclaimer “past performance does not guarantee future results,” the author explains how hiring and promoting based on historical track records, no matter how accomplished, can be insufficient for 21st century managerial challenges. Physical attributes, intelligence, specific talents, and experience are not enough in the volatile, uncertain, complex, and ambiguous business environment, which is also an applicable consideration for investment practitioners in a globally competitive profession.
• Evaluating Target-Date Glide Paths for Defined Contribution Plans: The challenge of target-date glide path selection for defined contribution plans requires a compromise between the competing goals of (1) generating an adequate level of lifetime income consistently over the course of retirement and (2) limiting the risk of capital loss near and during retirement, which is particularly important for participants who withdraw balances over shorter horizons. This compromise cannot be achieved through objective analysis alone; it must be informed by the subjective horizon and risk preferences of the sponsor acting as an agent for the plan participants. Two employers, each offering a defined contribution plan with similar participant demographics and employee benefits, might quite rationally select different glide paths because of different preferences.
• Factor Investing: When Alpha Becomes Beta: Many sources of alpha have become easy to identify and widely replicated over time. Such systematic return drivers, or factors, occupy the space between traditional beta and alpha. They represent investment strategies that require skill beyond passive investing but not the complexity necessary for alpha generation. Factor investing can provide significant benefits to investors through controlled risk exposures and lower fees relative to active investing.
• Becoming a First-Class Noticer: There are a number of obstacles that interfere with the detection of ethical failures within an organization. The author outlines them and offers a series of steps to overcome them.The inability to identify and address ethical failures within an organization begins slowly but may result in that organization’s undoing. The author suggests reasons for this inability and ways to remedy it. Conflicts of interest also affect objectivity. A real-world example is the business model of auditing firms; their job is to conduct an arm’s-length review of their clients’ operations, but at the same time, they often consult for those same clients to generate an ongoing revenue stream. Questionable ethical judgment may often begin with small missteps designed to correct a relatively small issue. Executed with good intentions, the “remedy” may lead to disaster, such as occurred in the trading sides of investment banks. The author cites the examples of Jérôme Kerviel and Kweku Adoboli. Nick Leeson’s similar transgressions at Barings led to that bank’s demise.
• How to Avoid Being Misled by History Lessons: One of the most striking features of the financial crisis has been a scramble to find useful lessons and insight into the events of the past. Ben Bernanke’s in-depth study of the Great Depression guided his tenure as chairman of the Federal Reserve while Carmen Reinhart and Kenneth Rogoff’s history of national debt has shaped global debate about how indebted states should be allowed to become. Mark Harrison, CFA, wonders if investors can learn from the objectivity and techniques of historical scholarship.

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